What Investors Should Know About Preferred Stocks

In an effort to increase returns in the face of low interest rates, many
investors have turned to preferred stocks. According to the
Wall Street Journal’s "Intelligent Investor" column, increased investor interest is
likely due to the stocks’ relatively high rates of return (which
average at about 7 percent) and the fact that preferred stocks have first
claim on a fund’s dividends (“Preferred Stock: Are Those Juicy
Yields Worth the Extra Risk?”
Wall Street Journal, Feb. 5, 2011). Additionally, the income from preferred stocks may be
taxed at a lower rate than income from some other investments, including
bond income.

Of course, there are problems with preferred stocks – perhaps very
big ones – but, unfortunately, many investors are completely unaware
of what those problems are. In his column, Jason Zweig of the
WSJ summarized the pitfalls of preferred stocks for his readers:

First, while preferred stocks seem to be lower risk than conventional stocks
and some bonds, they are not low-risk products. The interest on the stocks
can be suspended at the issuer’s will and the stocks themselves
can be retired without notice (also at the will of the issuer). Additionally,
the vast majority of preferred stocks are based on the financial sector,
which leads to an
overconcentration in one area of the economy and increases the risk of loss. Overall, the
level of risk in preferred stocks typically ends up being higher than
some other investments, even that of junk bonds.

Second, the tax benefits of preferred stocks typically only apply if the
preferred shares were held for a particular period of time. In many cases,
the assets change often and the preferred shares may not be held in the
fund long enough for the investors to receive the tax benefits. Since
this isn’t anything the investor can control, it may be unwise to
count on the lowered tax rate.